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Essentials of successful Islamic banking.

Islamic banking, as some instances in post-communist Russia have shown, can provide business solutions even in situations where the conventional banking techniques fail to accommodate. The conventional interest-based banking is mainly a business of financial intermediation between savers and entrepreneurs. It earns its profit by borrowing at one rate of interest from those who have surplus and lending it a higher rate to those who can use it profitably.

Islamic Banking, on the contrary, is sharing the fruits of economic activity generated through intermediation of savers and investors. The reason for elimination of interest in banking transactions is its prohibition in Islam. The injunctions against interest, synonymous to riba, are explicit and the word, under various connotations of prohibition, appears several times in the Holy Quran. It extends to financing for trade and industry involved in prohibited goods and services.

Islamic banking is emerging in an era when the world is settling down to a free market economy and when phenomenal changes are taking place in the global economy. A free-market economy envisages three essential features - free trade, open capital market and minimum governmental intervention. The vagaries of protectionism and regionalism are transforming the economy to free trade and globalism. The changes could provide ample scope for the Islamic banking to grow and work in competitive environment. Requisites of Islamic Banking

Islamic banking, being an integral part of an Islamic economic system can be practiced more effectively in an environment which conforms with the tenets of Islam. Thus there are some essential requirements for a successful Islamic banking, such as:

i) Supportive Legal Framework and Swift Judicial System: An effective legal framework ensuring speedy justice is essential for a good society, it is more so for the success of Islamic banking, because its investment risk is more than that of a conventional interest-based bank as its dealings are on profit and loss basis.

ii) Disciplined Entrepreneurship: It would minimise cases of malfeasance and mismanagement. Besides, a banker must extend from being merely a financier to a role-player in business. Although a Murahaba transaction in Islamic banking does provide an opportunity to banker to share in business, the Islamic banks generally limit themselves to being an inactive partner for their credit risk only. The real entrepreneurial role of an Islamic bank needs, therefore, to be increased.

iii) Conceptual Change from Credit Risk to Overall Risk Management: While it is difficult to predict, with any degree of certainty, the operating results of an enterprise and the magnitudes of profit and loss, all the same, it seems unjust if the party providing the capital is guaranteed a fixed and predetermined rate of return, and the other party undertaking the enterprise is made to bear the uncertainty alone. Under the circumstances, an Islamic banker has not only to focus on credit risk but also to view all the business risks of the enterprises in which he has invested the banks + money.

iv) Strong Ethical Values: The Islamic economic system offers a balance between the two extremes of public or social and private or individual ownership of property. The success of Islamic banking in a society is related to the extend of acceptability of the doctrine of trusteeship and transformation of the self-interested and profit-oriented behaviour of people into an altruistic and value-oriented behaviour.

v) Supreme Sharia Council: The function of Sharia Council in maintaining Islamic banking activities in a country within the orbit of Islamic injunctions is dependent on its legal status and the extent of implementation of its opinion.

The opinions of Sharia Councils of different countries may not necessarily be uniform. There is, therefore, a need for a Supreme Sharia Council representing Muslim community all over the world to deride about various issues confronted by Islamic banks. A beginning has been made in this direction by establishing the Council of the Islamic Fiqh Academy at Jeddah, Saudi Arabia under the auspices of the Organisation of Islamic Conference (OIC). But, its role has to be augmented.

vi) Uniform Accounting Standards: There is need for harmonisation of financial reporting of Islamic banks in respect, particularly, of the following:

a) The significant accounting policies on which the statements are based should be fully and clearly declared.

b) The methods of translating foreign currency transactions should be appropriately disclosed.

c) Appropriate and sufficient disclosures regarding the quality of banks - assets is of much concern to the depositors.

d) Additional disclosure of the nature of the financial contingencies and commitments (Non Funded Liabilities) of the banks in their financial statements.

vii) Committed Management: If the management of a bank is determined to step into the business of Islamic banking, it can easily evolve a strategy for the same, formulate a plan for a specific time-frame and implement it accordingly.

viii) Progressive and Modern Outlook: In order to ensure successful management in Islamic banks, there is need to apply all the available modern tools of managing corporate business, including management of human assets, offices, information resources, marketing etc.

ix) Body to evaluate Islamic Financial Institutions: In order to ensure quality and standard in management of islamic financial institutions and to build confidence of the general public in Islamic banking, there is need to establish some professional body-responsible to define professional standards and ethics and other aspects of Islamic financial institutions. It may also certify the level of financial health of such institutions.

Risk Management

The risk profile of an Islamic bank is higher than a conventional interest-based bank. The most common areas of its business risk include:

i) Credit/Investment Risk: It includes the risks of bad debts, non-recovery of a desired rate of return, fluctuation in the market price of investments, lower or nil dividend rate etc. As most of the investments of an Islamic bank are on profit and loss basis, its risk of variation of rate of ultimate return to the bank on its investments is more and it has, therefore, to follow a more sophisticated, effective and rigorous policy of its credit management.

ii) Liquidity Risk: The more the assets of a bank are in liquid form, the lesser is the risk of its technical insolvency, but equally less is the profitability of the bank. The banks need to pursue a policy depending on structured liquidity management related to their investment policies and one golden principle would be to match the maturities of deposit with the maturities of investments. The principle of + financing short term assets with short term liabilities + should continue to be applied.

iii) Exchange Risk: The Islamic banks, in their usual course of business, should not have positions in any currency as speculation is not permitted in any manner. However, in cases of profitable investment opportunities in mismatched currencies, the managements of Islamic banks should adopt adequate measures to protect the inherent risk in such transactions.

iv) Risk of Changes in Government Policies: Islamic banks are more prone to the risk of changes in government fiscal and monetary Policies as they participate in the profit and loss of the business enterprises than the conventional banks. Conventional banks are secured to get back their principal along with interest whereas Islamic banks have to participate in the actual results of their business. Before making any investments, Islamic banks have to make provisions for any unforeseen changes in the fiscal and monetary policies of the country.

Product Development and Implementation

The role of an Islamic banks is to mobilize savings on a large scale, pooling money from savers with different sums to invest, for different periods a different risk levels through its various products conforming to Sharia. Some of the Islamic banking products whose conformity with Islamic Sharia has been established are:

i) Generation of Deposit on Profit and Loss Sharing: Conceptually, all deposits generated on profit and loss sharing basis should be invested in non-interest based instruments while income earned therefrom should be shared between the bank and its PLS depositors. Therefore, there should be a system adopted by an Islamic bank to ensure that firstly, the interest-based income should be segregated from non-interest based income, if any and, secondly, the basis of sharing of profits between the bank and its depositors of various categories should be predetermined.

While different modules can be developed for distribution of profits, most of them are based on (a) calculation of average non-interest based earning assets and average remunerable PLS liabilities, (b) calculation of average amount of shareholders + equity of the bank, (c) calculation of distributable non-interest based income, (d) decision about the basis of distribution of non-interest based income between the gross amount of PLS liabilities (calculated at (a) and shareholders+equity (calculated at (b), and (d) on application of weightages on the basis of varying maturities of deposits and calculation of rates of profits and percent per annum.

ii) Modaraba: A modaraba has been defined as a business in which a person participates with this money and another with his efforts or skill or both his efforts and money. Their proportionate share in profit is determined by mutual agreement but the loss, if any, is borne only by the owner of the capital. Modaraba has proved as the best available source both for generation of deposits and/or investment of banks + funds.

iii) Participation Term Certificates: A participation term certificate (PTC) is a method whereby funds can be generated for a specified period on profit and loss sharing basis. An Islamic bank, subject to the relevant laws in a country, may issue Registered of Bearer PTCs of a fixed denomination for a fixed period on the basis of payment of a share of the banks + profits to the PTC holders. A provisional rate of profit may be applied subject to a final adjustment at the time of declaration of annual profits by the bank.

iv) Unit Trusts: Unlike Modaraba Certificates or Mutual Fund Certificates, which cannot be repurchased by the company issuing these certificates, the Unit Trust Certificates can be sold and repurchased by the company issuing them. The Unit Trust method can be used by Islamic banks both for generation of deposits and investment of their funds.

v) Modes of Financing: The modes of financing are permissible under Islamic banking, are (a) loans on a service charge, which is the percentage of annual administrative expenditure to the average annual assets of the bank, (b) loans without a service charge (Qarz-e-Hasna) i.e., some portion of an Islamic bank + C funds can be used for realizing such social responsibilities as making interest-free loans to deserving persons for education and/or medical treatment or other noble objective, (c) Bai-e-Muwajjal or Morhaba i.e for purchase of goods by banks and their sale to clients at mark up in price on deferred payment oasis, (d) leasing and hire-purchase (Ijara) which is a contract allowing use of land, building, equipment of other fixed assets for a specified period in exchange for payment in form rent and is broadly classified as Finance Lease and Operating Lease, (e) Musharika, which is an arrangement of partnership between the bank and its client under which bank provides capital finance as per terms agreed, with profit and loss shared in agreed ratios, and (f) rent sharing.

Out of the modes of financing, the Islamic banks generally prefer Murahaba at (c) for its simplicity and similarity with lending under conventional interest-based banking. However, Islamic banks should have an in-built mechanism to review the Islamic viability of various other existing banking products as additional modes of financing. While designing Islamic banking products, due care should be taken that they have (a) properly structured instruments, (b) detailed documentation, (c) well defined operative system and (d) Sharia approved accounting/audit standards.

There is also need for further research and development of new Islamic banking products especially in the area of inter-bank dealings and financing of infrastructure projects with long gestation periods. The Muslim Commercial Bank (MCB) of Pakistan has recently decided to introduce two new products, namely Musawama Facility and Lease-cum-Equity Financing.

The Musawama Facility (MF) is being used by the MCB for financing purchase and sale of cotton. Under the Musawama agreement, the customer requests the bank from time to time, to purchase a specified quality and quantity of cotton from the market. The cotton remains in the possession of the bank and the customer purchases the same from the bank at a national price (NP). The NP is adjustable with the purchase price at the expiry of the MF. The period of transaction is 180 days or the ending of the cotton season i.e. 31 August, whichever is earlier. The purchase price is the average market price for raw cotton of specific grade as notified by the Karachi Cotton Association. As security for the due and prompt performance of all the obligations, the customer furnishes collateral/securities as agreed with the bank.

The Lease-cum-Equity Financing (LEF) has been evolved by the MCB in order to finance big industrial projects taking longer period for completion and ultimate commercial production. The client is given an option to convert the amount of lease into equity shares in the name of the bank. The bank can thus earn lease rentals during the construction period and start sharing in the profit or loss of the enterprise as soon as the lease amount is converted into equity. The MCB has used LEF in financing a large power project in Pakistan.

Difficulties and Impediments for Islamic Banking

Although Islamic banking has been accepted as an alternate, independent system of banking free from riba, yet it is still passing through a host of difficulties and impediments, namely:

i) Financial Frauds in the Guise of Islamic Banking: During the last two decades, there have been cases of financial frauds perpetrated on the small savers under the guise of lucrative and regular financial profits using the name of Islamic techniques of financing. In Pakistan 70 and in Egypt 50 financial companies claiming Islamic business misappropriated public money and fled.

ii) Doubts about instruments used in Islamic banking: Certain instruments used by Islamic bankers are still under criticism of some Islamic jurists. Doubts have been particularly raised regarding sale and purchase of currencies and Murahaba and financial lease. The Federal Sharia Court of Pakistan have given a judgement that the current form of mark up financing in the shape of Murahaba is not in accordance with the Islamic injunctions.

iii) Inadequate Economic, Financial and Legal Infrastructure: In most countries where Islamic banking has emerged, common areas of concern are known to exist, namely that their economic policies are lop-sided and regulatory policy volatile and without a uniform regulatory framework, fiscal and financial disciplines are lacking, and that their legal frameworks and taxation structures are generally ineffective and not conducive to Islamic banking.

I would like to stress that there is need for a permanent forum for cooperation and dissemination of Islamic banking knowledge in the world. I also think that institutions like the Islamic Development Bank could be of assistance to Islamic banking. Islamic bankers, however, should focus attention on two major areas, first, on the need to introduce Islamic banking as a separate stream of knowledge, and secondly, on developing a mechanism whereby the surplus funds from Muslim countries could be moved to deficit Muslim countries through channels of Islamic banks. I would suggest that the subject of Islamic banking should form part of university curriculum of Muslim countries, and that greater cooperation and integration among Islamic banks should be increased to a point where the possibility of optimal utilisation of Islamic funds could be ensured.
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Author:Lawai, Hussain
Publication:Economic Review
Date:Oct 1, 1994
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